Maximising Value To The Entrepreneur Finance

Essay
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Chapter 12
Entrepreneurial Finance
"Id say its been my biggest problem all my life... its money. It takes a lot of money to make these
dreams come true." Walt Disney

Learning Objectives
After reading this chapter you should:Understand the centrality of maximising value to the entrepreneur to the nature of entrepreneurial
finance and recognise the terminology used in new venture financing;
Be able to describe how finance and its sources are intrinsically linked to the new venturing process
from inception of an idea to harvesting of the investment;
Be able to appreciate the key operational imperatives for planning a new venture such as funding,
cash-flow and profitability;
Be able to relate classic financial theory to the practice of new venturing, leading to better financing and
investment decisions and a higher success rate for a new enterprise.

Summary of Chapter
Introduction
Application of Financial Theory
Funding: Debt or Equity?
Staging of Finance to Key Milestones
Sources of Finance and Stages of Development
Case Box: Facebook
Negotiating a Deal with an Investor
The Business Model
The Business Model
Due Diligence
Managing Cash-Flow & Profitability
Determining Financial Needs
Valuation Primer

Use of Real Options in Mitigating Risk

Financial Contracting
Harvesting and Exit Strategies

Introduction
Statistics on start-ups points to very low odds of success. Although it is difficult to define what is meant
by failure, proxy data indicates the risk to the both the entrepreneur and investor is very high. In the
UK, for example, 75% of start-ups fail within the first three years . A study of 128 UK start-up exits
reported a highly skewed distribution of returns, with 34% being a total loss, 13% of the exits at breakeven or a partial loss, and 23% of the investments having an internal rate of return of above 50% .
This is not unusual is often the premise on which seed investors select start-ups for their investment
portfolio. Data from the Australian Bureau of Statistics (ABS) provide the following exit rates: of the
316,850 new business entries during 2007-08, 71.5% were still operating in June 2009, 56.8% were
still operating in June 2010 and 48.6% were still operating in June 2011 . Similar studies over different
periods and in different countries have found similar rates of failure. High failure rates have simply
become accepted as the inevitable cost of entrepreneurship offset by wealth creation, jobs and socioeconomic advancement. This to, some extent, extent creates a funding gap as the risk associated
becomes intolerable for many: the key problem being that most institutional investors, e.g. banks, are
accustomed to investing in much lower-risk investments (Table 1).
Table 12.1: Start-up Risk versus Requirements of Institutional Investors
Start-up Characteristics
Banks and Institutional Investors Prefer:
Business Inexperience
Track Record
Fluctuation of Cash Flows
Steady Cash-flow Profiles
New Markets & Complicated Technology
Easy to understand Market
High Growth Rates
Steady Growth Forecasts
High Debt Ratios
Low Gearing
This funding gap (Dia. 12.1) is often filled by risk-tolerant angel investors and Government schemes
that include a variety of supports linked intrinsically to structured programmes designed to de-risk starups for investor-readiness, such as accelerator programmes and prototyping schemes.

Diagram 12.1: Common Funding Gaps often Affect Transition from

Employee to Entrepreneur
While outside investors tend to mitigate these risks through diversification, entrepreneurs many not

have this option open to them. In choosing to launch a new business, first-time entrepreneurs, in
particular, face the prospect of loss of salary, using their savings and mortgaging their homes to finance
their business as they transition out of employment to focus on their new venture. On the other hand,
the Angel and Venture Capital industrys modus operandi is premised on achieving a few exceptional
returns among many failures or mediocre returns in each portfolio. Yet, there also legendary examples
of trade sales of 10 times revenue or better, 100 times earnings or 50 times investment to know that
such deals happen. There are also initial public offerings (IPOs) that point to staggering returns.
Case Box 12.1: Facebooks Millionaires
With the FACEBOOKs initial IPO valuation close to $100nb, rock-star U2s Bono is among a range of
finance heavyweights, including Goldman Sachs tycoon Yuri Milner, tech hotshots Zynga co-founder
Mark Pincus and PayPal co-founder Peter Thiel who became (if not already) billionaires overnight.
This does not include associates, friends and family members of Facebook founder Marc Zuckerberg
with his 2.3% stake now estimated to be worth $1.5bn .
This begs the question of how much of a role lady-luck plays Did Zuckerberg, as the entrepreneur, and
his early slew of investors happen to be in the right place and of the right time? Possibly, yet there are
underlying patterns in the few spectacular successes and the multitude of failures that may help us to
turn luck into a systematic process for achieving a high return? Studies show that there are some very
good predictors of failure and success. Of course, not every entrepreneur makes the right financial
decisions: Zuckerbergs co-founding partner, Eduardo Saverin, saw his 34.4% share diluted to less
than 5% in an early funding round and he was not the only one to miss out on a big pay-day. Ronald
Wayne, who co-founded APPLE with Steve Wozniak and Steve Jobs in 1976, sold his 10% share in the
company for a total of $2,300 that year: a position that would now be worth about $60 billion.
In summary, while we know that the failure rate of new ventures is high, we also know that many new
ventures failure is due to poor implementation underpinned by poor financial decision making. Many
ventures that survive fail to meet up to expectations or, perhaps, never should have been undertaken in
the first place. Sometimes, even when a new venture is successful, early financing mistakes prevent
the entrepreneur from sharing in the rewards of the company.
The contemporary definition of entrepreneurship focuses on the pursuit of opportunity by galvanising
resources outside the control of the entrepeneur. This definition suggests that entrepreneurship is a
multi-stage activity (Fig. 5.1).
Opportunity Recognition (e.g. screening ideas)
Galvanise Necessary Resources
Develop the Business (Operations)
Harvest the Rewards (e.g. Exit)
Figure 5.1: Entrepreneurship Process
The first step involves identifying genuine opportunities to create value. Not all ideas will fall into this
category, so the entrepreneur must use his or her experience to assess the opportunity. This is, to a
large extent, a cost-benefit analysis: to what extent do the potential awards exceed the opportunity cost
forgone by pursuing something else? If the opportunity stacks up then the entrepreneur must devise a
strategy to marshal resources, often outside his or her control, needed to realise the opportunity. The
particular challenge for the entrepreneur is that these resources are usually beyond their own means.
There are significant investment and financing decisions to be made at this point. Most new venture
requires multiple injections of cash before they are sustainable. These usually come at a cost to the
entrepreneur who may need to share equity in the business to acquire the resources needed. The third
stage requires execution of a plan to realise the opportunity. The common perception from investors is

that while good opportunities are relatively easy to find, entrepreneurs with the management skills for
execution are far less common. Outside investors often bet on the jockey as well as the horse. The
final stage of this process is where the entrepreneur harvests the rewards.
In May 2012, for example, Mark Zuckerberg sold a tiny fraction of his shareholding in FACEBOOK
prior to the IPO, netting him $1.1bn. Of course, every new venture will not necessarily yield the
expected rewards. The entrepreneur, therefore, needs to be critically aware of financial issues so that
the appropriate strategic and implementation decisions can be taken to achieve the expected rewards.
This chapter aims to provide students, prospective entrepreneurs and investors with the tools to
evaluate whether or not an idea is worth pursuing and how to apply financial theory to the decisionmaking process in planning a new venture. While many text-books on entrepreneurship focus on
institutional financing issues, such as sources of finance and valuation, the focus of this chapter is on
strategic decision-making, operations management and resource allocation.
While good ideas are a dime a dozen, it is much harder to find good people with the eye for detail to
implement them. Entrepreneurs, therefore, need to have the financial literacy if they are to turn their
visions into a reality or succeed in their endeavours to make themselves better off. Entrepreneurs need
to be comfortable with investment decisions and financing decisions as well as operations decisions
that affect cash-flow and profit. In the context of entrepreneurship, investment decisions focus on
whether or not to pursue a new opportunity by investing time and money in the creation of a new asset.
As the objective of any investment is to create value, we assess the assets ability to generate future
cash flows as well as the riskiness of those cash flows. Given a decision to invest, e.g. acquire an
asset, financing decisions, in contrast, focus on how best to finance the investment. Financing
decisions relate, for example, to: how best to acquire the necessary funds, how ownership of the new
venture should be structure, how much money should the entrepreneur use compared to the money
provided by outside investors and the type of financial claim by outside investors, e.g. debt v equity v
some hybrid, such as preferred stock, or the timing of funding rounds.

Application of Finance to the Entrepreneurial Context

The uncertainty of early-stage ventures requires an application of financial theory that differs
considerably to that in more structured and mature contexts, such as investing large corporations.
In large corporations, risk reduction is premised on the investors ability to diversify their investment
portfolio. In fact, corporations tend to have a well-diversified businesses. So, a corporate decision to
invest in a new venture is typically far less risky than an entrepreneur making a very specific decision
to start the same venture from scratch. Given that the entrepreneur is likely to be far less diversified
than any outside investors that he or she may bring on board, they are likely to have a different
perception of risk. Hence, their valuations of the new venture may be different even if they agree on
projected future earnings.
Corporate decision-making is usually vested in an executive team responsible for maximising
shareholder value. Decision-making in a new venture setting primarily resides with the entrepreneur.
However, in the case where the entrepreneur raises capital by bringing in outside investors, the
investor often insist in playing a role in decision making. In some cases, they may even bring in a new
CEO to replace the entrepreneur in this role.
Information problems between entrepreneur and outside investor are likely to be much more acute
than those between insiders and outsiders in corporations. Corporate shareholders tend not to get
involved in its day-to-day project decisions. In a start-up scenario, the entrepreneur has to convince
outside investors of the value of the project. Often the only way to do this is to prepare a well thoughtout business-plan and to offer contracts to outside investors that signal the entrepreneurs confidence
in the venture.

Incentivise schemes play an important role both in start-ups and corporations. In corporations,
performance bonuses and stock options can align management and investor interests. Covenants can
be used to discourage over-reliance on risky debt. In start-ups, contract terms between an outside
investor and an entrepreneur are usually designed to incentivise the entrepreneur to develop the
business quickly.
Uncertainty associated with new ventures is usually much higher than that of corporations.
Consequently, the use of options in contracts between investors and entrepreneurs is critical to both
parties hedging their bets on the likely outcomes of the new venture. Traditional valuation of a project,
involving forecasting cash-flows and discounting them back to net present value (NPV), does not reflect
the value of these options. Options that might be exercised include staging of capital injections and
linking them to milestones, abandonment, increasing the investment in the new venture, converting
debt to equity, equity buy-back .
Shares in corporations are usually liquid, i.e. can be traded easily in the markets. Hence, investment
decisions are based on the corporations ability to generate free cash flows and yield dividends.
Investing in new ventures presents a different investment scenario. These investments are not liquid
and often fail to generate free cash flows for several years. Returns on investment are, therefore,
harvested through liquidity events, such as public offering or trade sale. Because of the importance of
liquidity events, their timings are usually built-in to the business plan (as an exit) and factored into the
valuation of the investment.
The entrepreneurs priority in financial planning for a new venture is to balance retaining as much of
the financial claims as the business grows with maximising the value created by the business. Different
sources of finance are suited to the different stages of development.

Funding: Debt or Equity?

The entrepreneur has two basic choices when considering financing: debt or equity. Debt is borrowed
money secured in some fashion with some type of asset for collateral. Equity, on the other hand, is
contributed capital, usually in hard cash. Debt may be secured by a personal signature only while
equity can also be in the form of a contributed asset. New businesses often require long-term debt or
permanent equity capital to support major expansion and anticipated rapid growth. The advantage of
borrowing is that it is that it does not take a great deal of time to arrange and does not dilute equity
ownership. The disadvantages are that incurring debt subjects the venture to a long-term obligation. A
downturn in business or an increase in interest rates could result in the inability to service debt
payments. Unlike oil and water, debt, equity, self-funding, and external funding do mix well. Which to
use, and when, becomes a matter of individual option, although there are some pretty well established
precedents. Founders' personal investments, including both personal assets and family and friends'
equity and loans, are usually what finances concept or seed stage companies
The use of debt requires that some equity has come in first. A rough rule of thumb is that a dollar of
early stage equity can support a dollar of debt, if there is some additional security to back the debt.
Lenders often feel that a start-up has little ability to generate sales or profits and, consequently, will look
to have the debt secured. This debt will most likely be short-term debt for working capital to be paid
back from sales. Long-term borrowing (one year or maybe up to five) can be used for some working
capital needs, but usually is assigned to finance property or equipment that serves as collateral for the
debt. Debt does not decrease or dilute the entrepreneur's equity position and it provides. However, if
credit costs rise, or sales don't meet projections, cash-flows really get pinched and bankruptcy can
become reality. Top entrepreneurial companies use varying combinations of debt and equity. They
determine which is the most advantageous for the particular stage of growth they're financing. Their
aim is to create increasingly higher valuations or profit structures.

Staging of Finance to Development Milestones

The analogy is often drawn between undertaking a new venture and launching a rocket , the
probability of success low and slight deviations can lead the venture way off target. The long journey
proceeds in stages, at which of there is the option to either terminate (abandon) or make minor
adjustments. Early stage ventures tend not to generate enough profit to support further growth. Hence,
their development is fuelled by cash injections, just enough to get them to the next stage at which it is
hoped that the venture will be able to raise more cash on more favourable terms. A new venture is
essentially an experiment in which the assumption-to-knowledge ratio is high. Information about the
potential of the business opportunity may be incomplete. The entrepreneur may have more accurate
information about the product or technology whereas the investors may have more information about
the market.
How does the investor test the ability of the entrepreneur and how can the entrepreneur avoid giving
too much information about of the business idea away while convincing the outside investor that the
opportunity is worth pursuing? Information problems are largely solved by staging finance to
measurable performance milestones. Rather than committing funds up front, staging allows the
investor to "wait and see" if the entrepreneur can deliver on key milestones, such as the development
of a prototype or first sales.
Staging is also beneficial to the entrepreneur. Due to risk, early funding committed up front can be
costly to the entrepreneur as a large fraction of ownership would need to be exchanged for a relatively
small investment. The use of milestones not only allows the entrepreneur to retain greater ownership
but makes the investment proposition more attractive. Staging is usually event driven rather than time
driven, each event validating or invalidating assumptions about the venture . Achieving milestones
essentially allows the entrepreneur to de-risk the business.

Sources of Finance in Different Stages of Development

While each venture has its own unique life-cycle, there is a generally accepted model that outlines the
stages of business development, which require particular types of financing. The amount of funds
required by an entrepreneurial venture generally increases as the entrepreneurial life cycle proceeds
while risk reduces. Diagram 5.2 outlines the different sources of finance linked to the stages of
development of high-growth potential firms.
Start-ups usually burn lots of cash, particularly in the pre-seed stage. Cash is the basic fuel that will get
a start-up to a sustainable stage of development. Start-ups are usually limited to the type of financing
they can get, like personal savings used as equity or personally secured subordinated debt. On the
other hand, companies with a proven track record have a much larger choice of financing alternatives
such as banks, venture capital firms, private or public offerings. The challenge for start-ups is that
institutional investors are accustomed to investing in much lower-risk investments and unless that new
venture can generate positive cash-flows it will not be able to obtain significant debt-financing.
Friends, Family & Founders: It is important to point out that many SMEs do not access formal sources
of external finance. They, instead, tend to rely on trade credit from their suppliers or retained earnings.
The most commonly used forms of external finance include: bank funding; either loans, credit cards or
overdraft. Only a minority use equity finance from either venture capitalists or business angels10. Startups also use personal finance to fund investment and growth or seek finance from informal sources like
friends and family (Diagram 5.3).
Diagram 5.3: Use of External Finance by SMEs in UK 2011
Source: Source: SME Finance Monitor (November 2011)
Data on the extent to which personal finances of founders, family and friends are used in new venturing
varies by study but there are numerous examples of very successful companies that were
bootstrapped or self-funded during start-up. Bootstrap start-ups have to find a way to attract sales

quickly, so they are forced to develop a product that customers need, and to find customers who are
willing to pay for it immediately.
Case Box 12.2: Hewlett-Packard -An Example of Bootstrapping
As far back as the 1940s, two young graduates from Stanford University, Bill Hewlett and Dave
Packard, with a mere $538 in start-up capital begun their entrepreneurial endeavours in a garage in
Palo Alto as they continued their collaboration with mentor Professor Frederick Terman. The professor
watched his prime protgs graduate and after three years later, Terman managed to entice them back
with Stanford fellowships and part-time jobs. He suggested their first really marketable product -- an
audio-oscillator based on a principle of negative feedback hed taught them. Soon after, the partners
won their first big business!
Diagram 12.4: 367 Addison Avenue Palo Alto, Hewlett-Packard Start-Up and Birth-Place of Silicon
Valley
Disney ordered eight oscillators to fine-tune the soundtrack of Fantasia. This provided their first
injection of working-capital to move their premises and hire employees. This genesis story of HewlettPackard, a $43bn company with over 80,000 employees and bell-weather of the DOW Jones, has
inspired many engineer-entrepreneurs.
Angel Financing: With limited resources, it is very difficult for an entrepreneur to sustain growth through
bootstrapping, in which case external financing must be pursued. Friends, family and founders (3FS)
can typically invest modest amounts of money, normally below $25,000. At the other extreme of the
equity funding spectrum, most venture capital funds are currently investing a minimum of $500,000.
Business angels are high-worth individuals, often experienced entrepreneurs, who provide financing
and expertise to start-ups in exchange for an equity stake in the business. Business angels are often
thought of as a bridge, filling the equity gap between the 3Fs, and venture capital that invest relatively
small amounts in early stage projects with high growth potential. The most common exit point for an
angel is a successful trade sale or IPO.
Case Box 12.3: Tenmou is Bahrains First Business Angel Company
Tenmou provides relatively small amounts of funding, typically BD20,000 ($53,000) for 20% - 40%
equity. More importantly, Tenmous network of established entrepreneurs in the Middle-East island
kingdom offers a package of mentorship and funding to high potential start-ups. Tenmous investment
fund is financed by some of Bahrains best known businesses, including: Bahrain Development Bank
and Bahrains Aluminium giant, Alba . While angels
Diagram 12.5
have been a traditional source of financing for high growth ventures in the West, it is a new concept in
the Middle-East in which Tenmou hopes to contribute to the growing culture of entrepreneurship.
Venture Capital: Venture Capital firms typically invest a very large fund in a portfolio of entrepreneurial
ventures. Each fund is organised as a limited partnership, in which investors and the management
team are partners. Investors tend to be institutional and well diversified, such as pension funds,
corporations, insurance companies and banks. The expertise of VC firms is in raising new funds every
few years and identifying ventures with high growth potential in which to invest. Not all ventures are
suited to venture capital. VC investments are targeted at later-stage investments in which negative
cash-flow early on is offset by very fast growth rates later (revenue of 0 - $20m in four to five years) or
opportunities with very large market potential ($50m - $100m in revenue)
VCs monitor the progress of their investees to the extent that they often have a hands-on approach to
managing their investee ventures: they often sit on the board of directors, tie financing to strict
milestones, and appoint key managers. They often have industry-specific expertise and the majority of

their investments are in the high-tech fields. Not all VC investments pay off. The failure rate can be
quite high, and in fact, anywhere from 20% to 90% of portfolio companies may fail to return on the VCs
investment. On the other hand, if a VC does well, a fund can offer returns of 300% to 1,000% (3x to
10x). Because the failure rate can be high, VCs need to return 3x their fund size in order to give their
investors and themselves a decent return, so they look for 10x returns of the capital they invest,
understanding that few of their investments really hit that number. A 10x return sounds pretty significant
but not necessarily to a VC company or its limited partners. 10x on a $ 1 million investment barely
impacts on a $400 million fund that is supposed to return $1.2B. If VCs want to impact on their return
report card to their limited partners then they need a $4-10 million investment returning a $40-100
million return on exit in order to even begin to move their investment needle with their investors.
If the investment size isnt enough of a constraint, the time-frame horizon for most funds adds a second
blow to the chest. Typically a VC looks at an investment within a 5 year window in order to return capital
plus a return to their limited partners. VCs are best in post-seed investments (Series A) where the
amount of invested capital is significant and the timeline to exit is predictably shorter. The product is
built and customers like it and are paying real money for it. Dilution is usually more manageable, since
the product is in the market and generating traction.
Strategic Partner: The entrepreneur may consider a strategic investor partner in place of a VC or
Angel. This could be a vendor, customer, or other business partner with whom the venture is currently
working, who might be interested in investing in the company. A strategic investor often has deeper
pockets than an angel, but typically has a specific reason for investing so its always important to know
the reason behind the investment and to ensure interests are aligned. The investor may only want to
leverage the ventures technology for its own purposes or may want a favourable licensing distribution
agreement if the venture succeeds. Large corporations provide often provide venture funds as a
vehicle for advancing their technology and product-market strategies. Some corporations invest in new
ventures to develop them as strategic partners.
Government Sources: In many countries, provision of SME finance is seen an instrument of economic
policy. Many governments, therefore, put in place appropriate interventions, often targeting the funding
gaps left by private equity. In the US, the federal government provides subsidies on financing through
the Small Business Administration (SBA). Small Business Investment Companies (SBICs) access soft
loans, guaranteed by the SBA, and tend to invest it chunks between $250,000 and $5,000,000 in laterstage ventures . There are over 300 SBICs are in the US with $16 billion in capital under
management. In Europe, there are various schemes in place to foster technological innovation and
deal with the gap between public-funded research and technology spin-offs.
Innovation Vouchers: Public Funding Example for Innovation in Europe
Innovation vouchers are small lines of credit or lump-sum grants provided by governments to SMEs to
purchase services from public knowledge providers, such as universities, R&D Labs, with a view to
introducing innovations (new products or processes) . There has been some noted success with
innovation voucher schemes in Ireland, Singapore, Belgium, Cyprus, Poland and the Czech Republic.
The US offers a similar scheme, called the small business technology transfer program (STTR) .
Diagram 12.6: Extract from Irish Times
Although these schemes offer very small amounts of funding targets at seed and pre-seed stages,
many governments offer larger funding schemes for high-the companies who are further in their
development.
Trade Credit: Trade credit is, perhaps the most common of short-term financing for SMEs. If, for
example, a venture makes a purchase then receives the goods pretty much right away but does not
need to pay for 30 days then this is equivalent to getting a 30-day interest-free loan. However, it can be
costly as often discounts are offered to those who pay up-front or within a shorter period of time. If, for
example, a 2% discount is offered for those who pay within 10 days but the venture chose to pay on the

30th day then it is effectively borrowing the invoiced amount at 2% for 20 days, which is equivalent to
an annualised rate of 44% p.a. Entrepreneurs must consider this in managing their cash-flow.
Factoring: when a venture offers trade credit to its customers, it generates accounts receivable.
Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a
third party (called a factor) at a discount. Similarly, invoice discounting is a cash-flow solution that
releases the cash (up to 75% - 90% of the value of the invoices) tied up in debtors. It can be a
confidential facility and it also allows the entrepreneur control credit. When the full amount is collected,
the factor remits to the venture the remaining 10% 25% and charges a 1-2% fee.
Mezzanine Finance: Mezzanine finance is a form debt used by companies that are cash flow positive,
typically with revenues over $10m. Mezzanine debt capital generally refers to that layer of financing
rated between a company's senior debt and equity. Structurally, it is subordinate in priority of payment
to senior debt, but senior in rank to common stock or equity (Diagram 12.7). Most commonly,
mezzanine debt takes the form of convertible debt, i.e. subordinate debt with a sweetener in the form of
a call option (or warrant) to purchase equity. Although it is usually a more expensive source of funding
than a straightforward bank loan, mezzanine finance can be particularly helpful to fast growth
companies or businesses involved in leveraged buy-outs.
Diagram 12.7: Mezzanine Finance Fills the Gap
Mezzanine capital is typically used to fund growth, such as an acquisition, new product line, new
distribution channel or plant expansion, or in private business for the company owners to take money
out of the company or to enable a management buyout. With banks becoming more cautious and with
equity finance being expensive (it dilutes ownership), mezzanine finance can be an attractive source of
capital. In fact, many companies use an
efficient combination of senior debt, mezzanine finance, and equity to minimise the cost of capital.
Initial Public Offering (IPO): Private ventures can choose to "go public" instead of issuing debt
securities for several reasons but the most common reason is that capital raised through an IPO does
not have to be repaid, whereas debt securities such as bonds must be repaid with interest. An IPO is
essentially the offering of shares for sale to the wider public. It is often seen as a convenient exit
mechanism for VCs and early-stage investors to realise their investment gains, achieve liquidity and
diversify. The majority of firms who chose to go public need additional capital to execute long-range
business models, increase brand name and acquire funds for possible acquisitions. By converting to
corporate status, a company can always return to the market and offer additional shares through a
secondary offering. Getting an IPO right can be tricky: some recent IPOs, for example, have been
associated with huge first-day gains following by flops in share price. This volatility often leads issuers
and underwriters to time the IPO for market appreciation.. The time and cost of compliance with
Securities Exchange Commission (SEC) is also a critical factor as it can divert energies away from
core business activities
Case Box 12.4: The Facebook IPO
Facebook filed its application for an IPO with the securities exchange commission in early 2012 and
begun trading in May. Its initial valuation was estimated at $100bn, four times that when GOOGLE
went public in 2004 but the stock-market has not been kind to the social networking company since.
The share price dropped steadily from the first day price of $38 and by August it had fallen below $25.
This, in part, is due to the increasing scepticism about how fast FACEBOOKs profits and revenues can
grow. It must make money from its users rather than simply add new ones and it needs to find to do it
from mobile devices where there is little space for ads. Yet, on its current share prices, FACEBOOK is
still valued at over $50bn, which is staggering for a company only eight years old.
Public Debt: Later-stage ventures can, of course, seek to issue the bond market if they have a sufficient

asset base and require significant amounts of capital.

Although the life-cycle of every new venture differs, high-potential start-ups tend to plan using common
model for the stages of venture development.
Figure 12.9: Stages of Venture Development
There is usually a pre-seed (development) stage before the venture formally start-up. In FACEBOOKs
case, Zuckerberg and his friends at Harvard developed a web-site called FACESMASH that asked
users to judge students attractiveness based on their dorm-directory photos.
Needless to say Harvards authorities were not impressed. "THEFACEBOOK" formally started in early
2004 with co-founder, Eduardo Saverin, providing the most of the initial capital of about $30k.
Zuckerberg moved the business to California in early 2004 and bootstrapped his way through its first
few months. It wasnt long into its early growth before it got its first investors. Angels Peter Thiel, Reid
Hoffman and Mark Pincus invested $500,0000 for 10.2% of company and Sean Parker, Napster
founder, becoming Facebook President. Even the office painter, David Chloe, got paid in shares and
are now worth a staggering $240m.
A year later, FACEBOOK had over 5 million users and began to experience rapid growth, enticing Accel
Partners, the venture capital firm headed by investor Jim Breyer, to invest $12.7 million in Facebook for
a 15% stake, valuing the company at almost US$100-million. At the same time, it rejected an offer from
Viacom to buy the business for $75m. FACEBOOK continued near exponential growth for the next two
years and by 2008 a new round of investment, led by Microsoft implied a valuation of almost $15bn,
well over thirty time revenue.
Diagram 12.10: Facebooks Revenue Growth and Profits
FACEBOOK did not focus on early revenue growth and did not become profitable until 2009. It made a
modest $382,000 in revenue 2004, $9 million in 2005, $48 million in 2006 and in 2007 it made $153
million in revenue with reported $138 million loss, $272 million in 2008 with a $56 million loss and was
finally profitable in 2009 with a net income of $290 million.
This is not untypical for high potential ventures. During the development stage, the entrepreneur is
focused on product development and market feasibility and has not yet acquired the capacity for
revenue generation. During start-up, a venture hires new employees, invests in equipment etc. and,
therefore, may start to generate revenue during this period. There is usually a significant negative
cash-flow during this period that reflects investment in equipment, facilities, human capital and working
capital. In the early growth stage, revenue begins to grow but profit and cash-flow remain negative. In
many cases, revenue growth fizzles out but, for some, there is an inflection point beyond which the
slope of revenue growth increases. As in the case of FACEBOOK, rapid growth usually requires
significant logistical effort to garner the external financing to support corresponding growths in working
capital and fixed assets. By the time Microsoft invested, $240m in Facebook, its revenue growth was
300% p.a. but it was still generating a significant net loss and negative cash-flows. The aim of course,
it to start generating profits and positive cash-flows and, therefore, make returns to debt and equity
investors without the requirement for outside financing. This can be an obvious point for the
entrepreneur and investors to harvest.

Negotiating A Deal with an Investor

The deal defines the allocation of risk and returns to both the entrepreneur and investor and the details
are usually documented in a term sheet. Rather than get locked into detailed legal negotiations straight
way, the term-sheet facilitates a non-binding agreement between the investor and entrepreneur with
basic terms and conditions by setting out the amount to be invested and the ownership claims to which
the investor is entitled.

Entrepreneurs Main Concerns

Loss of management control of the venture;
Dilution of personal stock;
Repurchase of your personal stock in the event of employment termination, retirement or resignation;
Adequate financing;
Future capital requirements and dilution of the entrepeneurs ownership; and
Leveraging indirect benefits of the investor, such as access to key contacts;
Investors Main Concerns
current and projected valuation;
Evaluating the risk associated with this investment;
Projected levels of return on investment;
Liquidity of investment, security interests and exit strategies (downside protection)
Protection of the investors ability to participate in future funding rounds if venture meets exceeds
projections;
Influence over decision-making;
Consider, for example a deal where a venture is seeking funding of $5 million to carry it to the next
milestone. An investor is proposing to provide the capital in exchange for 4 million shares of common
stock. It is agreed that the entrepreneur is to retain 5 million shares of common stock.
The investor prices each share at $5m/ 4m share = $1.25 per share
The Post-Money Valuation is $1.25/share x 9 million shares = $11.25 million
The Pre-Money Valuation is $11.25m $5m - $6.25m
The post-money valuation is a measure of how much the outside investor believes the venture is worth.
This becomes more complicated when the deal includes terms beyond a straight-forward cash for
common-share swap. Preferred stock, for example, has a higher claim on assets and earnings than
common stock. Dividends must be paid before to holders of preferred stock before being paid to
ordinary shareholders but owners of preferred stock do not have voting rights or decision-making
powers. If, for example, the investor offers $5m in exchange for 3.6m shares of preferred stock
convertible on a 1:1 basis to common stock then it would allow provide him or her with some downside
protection if the venture does perform as planned yet facilitate to conversion to common stock if the
venture does better than expected. This deal would also allow the entrepreneur to retain a high
shareholding and, therefore, a more valued position. In this case the valuation would be:The investor prices each share at $5m/ 3.6m share = $1.39 per share
The Post-Money Valuation is $1.39/share x 8.6 million shares = $11.96 million
The Pre-Money Valuation is $11.25m $5m - $6.94m
It is important not to focus solely on the post-money valuation by the investor and to also assess the
"sweeteners" promised to the investor that could affect that valuation. Due the uncertainty associated
with investing in new ventures, the investor is likely to include a number of options, rights and

contingencies as part of any detailed agreement. In the example above, the investor might insist on a
warrant to acquire an additional 2 million shares if the venture fails to achieve a certain revenue
threshold in two years. A common provision often used to protect investors in the event of a lower
valuation in a subsequent funding round is a ratchet provision that prevents dilution of the investors
shareholder value. This is usually provided by warrants to acquire additional shares at a set price or
convertible stock with a floating conversion price. Other key provisions often included are:Voting Trust: Entrepreneurs assigns the investor if they dont perform. The investor has the ability to
take control, notwithstanding it is initially in a minority position.
Put provision: The investor may have the right to sell the business to the highest bidder if an exit is not
achieved by a given date.
Piggyback option: The investor may sell their shares anytime the business sells shares either in a
public offering or in a trade sale.
Drag along: The investor can force all shareholders to sell their shares if its VC receives an acceptable
offer for its shares.
Tag along: If a shareholder receives a favourable offer for its shares, other shareholders have an
option to notify the purchaser that they too wish to sell their shares.
Unlocking provision: If the entrepreenur receives an offer they dont wish to accept but the investor
does then the entrepreneur must buy the investor out.

The Business Model

Business plans are commonly used to document a business opportunity to potential investors and are
often considered an intermediary step between a strategy and implementation. There are plenty of
web-sites and other sources that will provide aspiring entrepreneurs with templates for business-plans.
From an investment perspective, it is much more common to assess the underlying principles that will
lead to revenue growth. These principles are collectively enshrined in what is referred to as the
Business Model. Business-plans for new ventures and start-ups differ considerably to those for
established businesses. The main difference relates to the accuracy with which future projections can
be made, the assumptions underlying established business plans tending to be much more reliable.
Financial projections for established businesses can, for example, be based on prior-experience
whereas those for new ventures are often premised on macro-economic data, conjecture and
performance of similar ventures. Planning is often based therefore on unproven assumptions such as:How big is the market opportunity?
What market penetration can the new venture achieve?
What is the tie-to-market for a new product?
A business-plan typically outlines a number of underlying assumptions about the new venture, e.g.
time-to-market, product cost, pricing, first customers, and sales targets. As the venture develops, these
assumptions get tested as hypotheses, either de-risking the investment (if the hypotheses are proved)
or triggering a re-evaluation of the venture (if the hypotheses are disproved). Milestones and financial
projections are, therefore, critical to outside investors and if the entrepreneur needs to be able to
articulate why a projection was not achieved and its implications for the business opportunity as the
venture proceeds. Investors typically seek evidence in a business-plan along three dimensions:The Entrepreneurial Team
Business Idea Merit

Evidence of Commitment
Qualification & Reputation
Youth & Experience
Track Record
Ability to Implement the Plan
Evidence of Traction & Partnerships
Ability to Function as an Effective Team
Technology Risk
Alignment of product to Market
Timing
Potential Size of Market Opportunity
Route to Market identified
No Fatal Flaws
Time & Capital Already invested
Salaries of Start-Up Team
Equity Buy-in For Achieving Key Milestones
Investors protected against early exit by start-up team.
A common problem for technology entrepreneurs is balancing the need articulate the merits of their
business idea without disclosing critical aspects that could be appropriated by others. Providing
evidence of intellectual property may signal to potential investors that the idea is based on deep-rooted
know-how that cannot be copied easily, thereby avoiding the need to disclose unnecessary secrets.
Where ideas are not protected by IP, the entrepreneur needs to be cautious in choosing a reputable
investor or at least ensure that they have sufficient first-mover advantage that stealing their idea would
not make much difference. There are differing views on what financial information to include in a
business-plan. However, it is commonly agreed that projecting financial performance of a new venture
is as hard as forecasting the weather . Investors often cite that prospective entrepreneurs over-state
sales projections whereas entrepreneurs often believe this to be posturing so that investors can
negotiate more a favourable deal. Yet financial projections provide the basis for entrepreneurs and
outside investors to come to a common understanding about the potential value of a new venture. One
common way to deal with this problem is to provide the investor with a long-term option, known as a
warrant, to buy more shares at a nominal price if the venture fails to meet key sales targets. This not
only signals the entrepreneurs confidence in the targets but de-risks the investors investment and
incentivises the entrepreneur to achieve the targets.

Due Diligence
Investors will always take reasonable steps to verify the accuracy of any business-plan before pouring
money into a new venture. Due diligence is a process in which all aspects of an investment decision
are validated . It can be expected that the investor will to conduct due diligence on all aspects of the
business-plan, including the entrepreneurs character and his or her team, recent financial
performance of the fledgling business and its ability to grow, customers and partners, the current

ownership structure of the business, validation of any IP and who has invested how much in the
business to date, a review of all compliance and regulatory requirements, and a review of any pending
litigation, insurance or taxation claims. This process checks the integrity of the entrepreneurs business
as well as provides a view on it is managed.
The investor is likely to incur considerable costs during due diligence and they will want to ensure that
the entrepreneur is acting in good faith during this period. To protect themselves, the investor may
request that the entrepreneur execute an exclusivity agreement whereby the entrepreneur agrees not
to proceed with acquisition discussions with any other party during the due diligence period. A penalty
may be agreed for a breach of this condition.
Due diligence should work both ways and entrepreneurs should also conduct due diligence on any
potential investor. A common mistake made by entrepreneurs is choosing the investor who offers the
lowest equity requirement for making the investment. The entrepreneur should seek references from
CEOs about what the investor was like to work with, assess the investors credibility in the investment
community as an enabler for future

Managing Cash Flow and Profitability

Managing cash-flow is critical in to a start-ups survival. Without cash in the bank, a new venture simply
cannot the bills - wages, rent, raw materials etc. Entrepreneurs often report that "on paper our cashflows seemed reasonably positive and the company to be making plenty of money but, in reality, we
are cash-poor and struggling to finance our day-to-day operations". All too often cash inflows seem to
be slower at coming in than the speed with which you are paying out cash and new business owners
soon discover a simple truth: first you pay for goods or services then eventually your customer pay you.
This creates a drain on cash resources. The period between payment of cash and receipt of cash is
called the "cash gap". It reflects a how long your goods sit as inventory, how long it takes for your
customers to pay and how long you suppliers gives you to pay them.
Diagram 12.11 Cash-Flow Cycle
Cash-flow is best explained as a cycle. The cash you use in your business to acquire resources to sell
products or services to your customers is then collected by way of customer payments. These
payments are used to pay outstanding bills you have and also to re-invest in more resources to sell
additional products or services.
The interval between interval between payment of cash and receipt of cash must be financed and the
longer the time the more interest is paid on borrowings form a lender, consumer valuable working
capital. Lets take the following illustrative example to how the cash gap can drain financial
Fixed Assets 1,000 1,000
Curren
Lets assume that the interest rate being charged for a short-term facility in 2011 is 6%.
Normally accountants recognise income at the time a sale is made irrespective if it is for cash or on
credit. Using the accrual system, it is possible to record revenues before cash payments are actually
received. Similarly accounting expenses do not necessary equate to negative cash-flows as the
company may have purchased items but not yet paid for them. Depreciation, which is expensed
against profit, does not affect cash-flow. This partly explains why highly profitable ventures can have
negative cash-flows. Common cash-flow problems include:Reason
Solution

Volatility in Critical Business Parameters

Monitor for trends, e.g. slowing sales, rising costs.
Use risk management tools to reduce exposure to changing interest rates, commodity prices and
exchange rates.
Use insurance to protect against loss of assets are income.
Excessive Capital Tied up in Inventory & Equipment
Ensure Effective Raw Materials planning
Reduce in work-in-progress (WIP)
Turn over excess stock, even at a discount
Consider using leasing solutions for equipment instead purchasing
Long Term Assets bought by Cash
Use longer-term lending solutions for capital assets.
Match the length of the loan to the life of the asset.
Collecting Accounts receivable too slowly
Have a system in place to follow up overdue accounts.
Use electronic payment solutions.
Take post-dated cheques.
5. Failing to put excess cash to work
Look for Cash Reserves Invest

Determining Financial Needs

Free Cash Flow (FCF) is a more conservative description of cash-flow than EBIDTA. It represents the
cash-flow after expenditure on maintaining on investing new capital is made to support growth in the
company.
where
EIBIT = Earnings Before Interest & Tax
TR = Tax Rate
Capex = Amount Invested in New Capital
Glossary of Terms
Entrepreneur
Chief Executive Officer (CEO)
Trade Sale
Initial Public Offering (IPO)

Venture Capital (VC)

Debt
Equity
Common Stock
Preferred Stock
Convertible Stock
Debt Covenant
Stock Option
New Present Value (NPV)
Liquidity Event+
Valuation
Profit
Free Cash Flow
Business Angel
Collateral
Factoring
MBO
LBO
SBIC
SMA
Innovation Voucher
3x
Senior Debt
Subordinate Debt
Ratchet Provision
Term Sheet
First Mover Advantage
Due Diligence
Warrant